How to build retirement income … and leave a legacy

Over the years, Hawaii real estate has proven to be a popular and sound investment.

Today, thanks to the substantial rise in property values, many investors are sitting on real estate that has enjoyed significant gains in value. However, these same property owners face a burdensome capital gains tax, modest net rental income, and the headaches of being a landlord.

If this sounds familiar, read on. There are ways to increase your cash flow for retirement, simplify your life, and wisely exit the real estate management business. However, a sound strategy is necessary if you want to bypass the sometimes considerable capital gains tax due upon the sale of investment real estate, and invest the sale proceeds in a way that ensures steady cash payouts for retirement.

A strategy that offers you these benefits and allows you to leave a proud legacy for your community is a charitable remainder trust.

With a charitable remainder trust (CRT) you can:

• Bypass capital gains tax, so that all of your principal is reinvested;

• Receive a steady stream of income for your lifetime;

• Get an immediate and substantial income tax deduction.

The benefits of a CRT can best be illustrated with an example.

Assume John and Malia, ages 68 and 65, bought an investment condo for $100,000. Its current fair market value has grown to $400,000 and its depreciated tax basis is $50,000. They plan to sell it in July 2012. With a combined state and federal capital gains tax rate of 22 percent (or higher, considering the 25 percent federal rate on recaptured depreciation) the tax due on sale will be at least $77,000 — [$400,000 - $50,000] x .22 = $77,000 — leaving only $323,000 to re-invest to produce income.

If John and Malia create a CRT instead and convey the property to the CRT prior to sale, the sale is free of capital gains tax and the CRT will have the full $400,000 to invest for future income for John and Malia. That is CRT benefit No. 1.

Assuming John and Malia opt for a CRT that pays them a 5 percent variable income for their joint lifetime, they will receive $20,000 in year 1 [$400,000 x .05 = $20,000.] This is CRT benefit No. 2.

Using the variable income option, the income is re-computed annually on the trust’s year-end principal. If we assume the trust can earn 6 percent while paying 5 percent over John’s and Malia’s joint life expectancy (25 years by IRS tables) their projected life income is $564,864 and projected gift to charity is $512,973.

Lastly, when the CRT terminates, the trust remainder will pass to one or more 501(c)(3) charities of choice, and John and Malia therefore will receive an immediate charitable income tax deduction of $243,312. This is CRT benefit No. 3.

In summary, by using a CRT to liquidate their $400,000 investment real estate, John and Malia will:

• Bypass capital gains up to $350,000;

• Increase their lifetime income substantially while eliminating their landlord headache;

• Receive an immediate $243,312 charitable income tax deduction;

• Leave a meaningful gift for charity estimated at more than $500,000.

This example does not discuss the technical issues in CRT planning that a good estate, tax, or financial planner needs to consider, and anyone considering a CRT should consult a professional adviser.

The option to use a CRT “exit strategy” for investment real estate, or any highly appreciated asset, is powerful. For wise investors who want to positively impact their community, the CRT is one of the most powerful strategies Uncle Sam has provided so you can “do well while doing good.”

Michael Coppes is an attorney with more than 30 years of experience, now retired from law practice and serving as associate director of estate and gift planning at the University of Hawaii Foundation. Reach him at michael.coppes@uhfoundation.org